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Change Grabs China

While financial liberalization makes it easier to do business in China, major economic, cultural and political shifts could alter its course.

China is in no danger of losing its position as the world’s factory floor anytime soon. But as it enters the Year of the Dragon—the fire-breathing mythical beast of the Chinese zodiac that can herald change and turbulence—the country is taking bold steps to internationalize its currency while facing headwinds of change on several major fronts that could drastically alter its course. The dragon, which symbolizes traits ranging from strength and self-assuredness to imperiousness and brashness, reigns from this January until Feb. 8, 2013, and appears especially apropos at a time when China faces an array of economic, cultural and political challenges—including a major change in leadership this fall —that could send the country in unexpected directions, not all of them positive for companies doing business there.

Those challenges include escalating prices and the resulting higher production costs, a real estate bubble and a shortage of credit. Costs, in fact, have been rising for at least a few years, prompting firms to look for alternative sources of production

But top of the list and now unfolding as the biggest potential game changer of all is the Chinese government’s gradual effort to enable commercial transactions to settle in renminbi (RMB), which provides mainland China-registered companies with more flexibility in obtaining capital.

“The steps the Chinese government has taken toward the internationalization of the RMB are nothing short of spectacular,” says Alfred Nader, vice president of corporate strategy and development for Travelex Global Business Payments, which Western Union bought from Travelex last year.

Nader says the company benefited from China’s currency liberalization last year when it became the first non-bank payments specialist to offer direct renminbi payments and settlements in mainland China through its GEO clearing network.

“Our customers are now able to trade directly with authorized Chinese companies, which helps them strengthen trade relationships with suppliers and mitigate against foreign exchange risks,” he says.

The first steps toward internationalizing the currency began in mid-2009, when the government introduced a limited pilot program to settle trades in renminbi. In August 2011, the program was expanded to cover all of China and the rest of the world, so companies located in mainland China as well as outside of China could settle all import and export transactions in renminbi.

That prospect is looking increasingly attractive to companies exporting goods from China.

Dean Krotts, a partner at Bajer Design & Marketing in Wisconsin, says his firm currently makes payments in U.S. dollars. “But we are discussing changing that as the RMB continues to appreciate and we are the ones getting hit with the conversion expense,” says Krotts, whose private firm, with sales approaching $100 million, produces home products sold at retailers including Wal-Mart and Target.

In addition to linking its settlement system with the mainland’s, the Hong Kong Monetary Authority introduced a bond market that allows corporates and financial institutions to issue renminbi-denominated bonds in Hong Kong.

The bond offerings gave companies a new and less expensive way to raise capital, since Hong Kong funding costs are typically lower than those on the mainland, as well as the ability to send renminbi-denominated profits outside the mainland by paying interest to investors.

Several multinationals have issued the so-called dim sum bonds so far, including McDonald’s, Caterpillar and Volkswagen. The market’s volume grew to more than $16 billion in 2011 from $6 billion the year before.

In January, the Chinese government began promoting an overseas direct investment program that allows companies registered in China to shift capital denominated in renminbi to offshore jurisdictions to invest in subsidiaries and acquire assets.

Sam Xu, executive director at J.P. Morgan Treasury Services, who until six months ago led the group developing the division’s local infrastructure and capabilities in China, says that while strict rules remain on how much capital can be transferred, the changes have greatly increased companies’ ability to raise less expensive funding for their subsidiaries in China and/or better mitigate FX exposure resulting from the expected appreciation of the renminbi against the U.S. dollar. And in November, Xu notes, the government began allowing offshore companies to channel renminbi proceeds raised outside of China, primarily in Hong Kong, back to their subsidiaries in China in the form of capital injections and shareholder loans.

“So now foreign companies can raise funding denominated in RMB and, subject to China’s foreign investment policies, bring it back to China to invest in a subsidiary, engage in mergers and acquisitions or provide a shareholder loan,” Xu says, adding that J.P. Morgan facilitated its first renminbi-denominated shareholder loan for a European company in December, one of the first done in China.

Another indication of the renminbi’s march toward becoming a reserve currency alongside the dollar and a few others emerged in January when officials in London and Hong Kong announced plans for London to become a second offshore location to settle and clear transactions in RMB.

“If you want a currency to be truly international, you want it to be settled and cleared as close to 24/7 as possible,” Xu says.

Such governmental steps are essential, but companies and their bankers must also turn the changes into actionable strategies.

“There have been enough incremental changes and time for companies to digest them to cause a significant shift forward,” says Ron Chakravarti, managing director in Citigroup’s global transaction services unit.

In 2011, Citi helped a global electronics company establish a “re-invoicing” center in Hong Kong that buys products from the company’s multiple manufacturing subsidiaries on the mainland and sells them to its distribution units around the world. Instead of having each mainland subsidiary juggle different currencies for invoicing and payment, and perform other treasury functions, the re-invoicing center serves as an intermediary for the inter-company flows.

The company’s manufacturing subsidiaries now sell and invoice only in renminbi, with payments received in bank accounts in Hong Kong. All treasury management processes are now centralized in Hong Kong at the re-invoicing center. This makes for far more effective liquidity management, with coordinated timing of payments, as well as improved foreign exchange risk management. In addition, the company avoids having liquidity trapped unnecessarily in its operations in mainland China.

“We’ve been in discussions with other clients since we facilitated this ground-breaking transaction mid-last year, and we believe more multinationals will be implementing similar advanced treasury structures for their China business,” Chakravarti says.

While financial liberalization makes it easier to do business for both Chinese and multinational companies, the most immediate challenge for those doing business in China is rising costs. Costs have been heading higher for at least a few years, especially since commodity prices skyrocketed in 2010, prompting nimble firms to look for alternative sources of production.

Christopher Bizzio, CEO of Mandarina Duck, a maker of designer luggage and accessories headquartered in Bologna, Italy, says the company’s production costs in China, where it manufactures about 40% of its goods, increased 11% in 2011.

“It’s starting to get to the point where we don’t have that big of a price advantage manufacturing in China compared to Eastern Europe,” where the company sources another 40% of its production, Bizzio says. He added that’s especially the case when transportation costs are considered.

In fact, a couple of Mandarina Duck’s raw material suppliers recently shut down, Bizzio says, because they were unable to find qualified labor and because the government has tightened credit to temper inflation. He says the credit squeeze is also pushing Chinese suppliers to manage their cash flows more effectively, in part by adopting just-in-time warehousing techniques. That means they don’t have excess raw materials in stock that can be used to fill orders quickly.

“For a foreign company, production times are getting longer because you now have to include about 45 days for those raw materials to be supplied,” Bizzio says.

The labor shortage is a long-term factor driving up costs. Although upward pressure on wages in some regions may lessen temporarily—the Chinese government is building 36 million housing units to draw workers to high-demand areas—demographic trends suggest the problem will only worsen.

“Now the working population is fairly stable, but it will decrease from 2015 on, so the labor force will grow scarcer and more expensive,” says Constance Boublil, an economist specializing in the Asia region at Coface, a credit insurance provider that’s a subsidiary of Nataxis. “The growth model based on a cheap and abundant labor force is eroding.”

Chinese wages have increased 20% since the start of 2010, Boublil says, in part because the generation created by China’s one-child policy is unwilling to make the same sacrifices as their parents and instead is demanding more compensation and benefits.

Boublil also pointed to legal changes stemming from worker unrest. Guangdong province, for example, passed regulations in late 2010 that created a labor dispute mechanism on a pilot basis and gave workers the right to strike. The year ahead may test those new rules and see them extended to other provinces.

That could put more upward pressure on wages, a development that the Chinese government appears to support at least in part as it seeks to grow China’s middle class and consumer base. One of the main objectives of China’s 12th five-year plan, the national government’s broad set of goals running through 2015, is to boost consumption so economic growth is less reliant on exports.

“Chinese consumption represents only 3% of world GDP, whereas the U.S. represents 18%,” Boublil says.

However, cost increases vary across geography and product lines, and some may have leveled out, at least for now.

“Cost increases in 2011 were realized in the first quarter,” Krotts says. “The final three quarters of the year were stable in terms of raw material and labor costs.”

He says, though, that Bajer Design recently experienced a 15% increase in rates to lease a new space, although the company sought the space in the complex where it had begun leasing four years ago and lower rates may have been available elsewhere. Krotts, who visits the company’s operations several times a year, says the labor market has tightened in the greater Shanghai area. “We can get people, but experienced ones come at a premium.”

And there’s talk of a general wage increase as high as 15% this year, Krotts says. “If our labor goes up by 15%, it’s a big cost increase to us.”

D.G. Macpherson, senior vice president and head of global supply chain and corporate strategy at Grainger, a distributor of facilities maintenance products, says the company hasn’t experienced significant overall cost inflation on the products it sources from China. “To date, the cost increases we’ve seen have been very product-specific, with substantial inflation on some products and others holding steady,” Macpherson says.

Some multinationals are turning to suppliers in inland China, where inflation has been much less pronounced.

“In addition to working with suppliers on the east coast of China, for the past several years we’ve focused on finding high-quality suppliers in central China and expect that region to become even more important over time,” Macpherson says.

Kristjan Drake, head of corporate treasury sales in China and Taiwan at Bank of America Merrill Lynch, says the bank has seen multinationals increasingly moving inland to cities including Chengdu, Chongqing, Wuhan and Changsha. The mayor of Chengdu recently outlined aggressive plans to create a world-class “auto industry zone,” Drake says, adding, “Supporting balanced regional economic development remains one of the tenets of the Chinese government’s 12th five-year plan.”

Producing goods in central provinces may be cost-effective, but getting them to the coast for export is not. “Transportation costs are substantial,” says Krotts. “It’s not like in the U.S., where you can produce goods wherever and ship them inexpensively to the coast.”

Bizzio says Mandarina Duck has searched inland China, but so far has found few manu-facturers that can produce its products. Instead, the company is tapping other countries. It started producing bags in Vietnam about six months ago and will begin shipping those products in February, Bizzio says, while the leather bags it started producing in India are already in stores in Italy. “The quality is exceptional in India—very good quality difference compared to China,” he adds.

Bank of America’s clients are large enough to operate in multiple Asian markets, and while China often remains the most significant market in terms of production and sales, they operate in other locations according to market factors, Drake says. “We’ve seen some of them shifting to India, a few Southeast Asian countries and even the United States, as the dollar depreciation makes their goods cheaper.”

Another factor that could impact companies producing or selling goods in China is the real estate bubble. According to China’s National Bureau of Statistics, residential real estate prices fell in December for the third consecutive month, after developers cut prices to increase sales, although prices were still higher than a year earlier.

The price bubble appears to be confined to luxury housing. But Bizzio says his firm has seen small-component manufacturers face financial challenges because their owners used their homes as collateral for loans, and now that collateral has plummeted in value.

Boublil says the luxury apartment bubble was confined to the biggest Chinese cities and the government has implemented measures to deal with it, such as introducing higher interest rates and down payments and limiting the number of speculative purchases per individual. Commercial real estate prices increased significantly in 2010, but in the last year appear to have become more affordable, she adds.

That’s partly due to the tightening of monetary policy by China’s central bank to tamp inflation—China’s consumer price index peaked at 6.5% last July—a move that slashed the availability of credit from official sources and led to unregistered credit agencies charging rates four or five times those of the banks. Boublil says registered banks in China provided 96% of financing in 2002 and that dropped to 57% in 2011, with the remainder provided by unregistered lending agencies. The shift doesn’t directly impact multinationals doing business in China, she says, but it raises costs for Chinese companies and could contribute to slower growth.

China’s fourth-quarter GDP grew 8.9% over the previous year, which was better than anticipated, although quarter-to-quarter growth was lower at 8.2%. Its 9.2% growth for 2011 as a whole far outpaced developed markets, and with China’s more than 1.3 billion people consuming only one-sixth of what Americans consume, the country offers bright prospects as a target market for multinationals. In fact, China’s retail sales grew 11.7% last year, well ahead of its GDP growth.

China is an especially attractive market for a company like Grainger given the country’s growth and strong manufacturing base. Macpherson says China has become “an increasingly important end-market for our distribution business.”

Ford Motor Co. sold 519,390 vehicles in China last year, a 7% increase over the year before. Nearly all of them were built in China, and the company plans to bring 15 new vehicles to the Chinese market by 2015.

“To keep up with market demand, Ford, together with its partners, are currently adding four new plants in China,” says Dave Schoch, chairman and CEO of Ford China.

However, companies seeking to enter the Chinese market face hurdles. Krotts says Bajer “hasn’t really cracked the Chinese market yet” because it remains so fragmented. “There’s no 300-store chain with central warehouses where you can ship big orders,” he says. “That’s probably 10 years away.”

Macpherson echoes that outlook. “While much of the infrastructure already exists, the process to go from a very fragmented space to a more efficient, consolidated distribution base is likely to take decades.”

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